TUTORIAL 5

Audit Reporting

Explain the function of the audit report.

 Auditors’ reports on financial statements should contain a clear expression of
opinion, based on review and assessment of the conclusions drawn from
evidence obtained in the course of the audit
 The auditors’ use the audit report to communicate their findings to all concerned
parties

For each of the following scenarios, state with reasons, which form of audit
qualification you would use in each case:

 The answer will depend on whether or not the student sees the potential outcome
of the lawsuit as being “probable” or “possible”. If probable a provision should be
provided in the accounts – Qualified opinion (except for) as no provision has
been made. If possible it should be disclosed as a note – Unmodified opinion

 The auditor would be unable to gather enough audit evidence - Disclaimer of

opinion

 This is an example of an adjusting post balance sheet event – Adverse opinion

 The amount involved is not material therefore it does not impact on a true and fair
view – Unmodified report

 This represents disagreement over accounting policies, amounts included in the

accounts and departure from GAAP. The amounts involved are likely to be
material – Adverse opinion
Audit Reporting

(a) Explain the potential effect on the each company’s final audit report of each of
the three issues identified as part of the audit.

Company A – limitation of scope; probably/possibly material; not pervasive;

therefore, ‘Qualified opinion’

Company B – unable to express an opinion on inventory which represents a

limitation of scope. As this is the clients sole product to the market place the
impact of inventory on the financial statements is likely to be material and
pervasive therefore, ‘Disclaimer of opinion’

Company C – material and pervasive (including effect on profits because of

interest on lease obligations); disagreement; therefore ‘Adverse opinion’

(b) Briefly explain what is meant by the term ‘going concern’ as the basic
assumption applying to the preparation of the financial statements of a
business.

Going concern means that the business will continue in operational existence
for the foreseeable future without the intention or necessity of liquidation or
otherwise ceasing trade. The auditors need to consider what the company’s
directors have considered about going concern when they prepared the
accounts, make their own judgement about whether the business is a going
concern and report to shareholders about these matters.

Note that ISA570 (revised) and ISA700 (revised) enhanced the auditor’s
responsibilities for reporting on going concern. In the audit report this means
including:
 A description of the respective responsibilities of management and the
auditor for GC;
 A separate section when a material uncertainty exists, and is
adequately disclosed, under the heading “Material Uncertainty Related to
Going Concern’, and;
 A new requirement to challenge the adequacy of disclosures for ‘close
calls’ in view of the applicable financial reporting framework when
events or conditions are identified that may cause significant doubt on an
entity’s ability to continue as a GC.

(c) State TWO indicators of risk that might threaten the continuance of a business
as a going concern.
 Behind with tax payments
 Behind with paying staff
 Loss of key management or staff
 Over-reliance on a small number of products or staff
 Unable to obtain credit from suppliers
 Legal claims against the company
 Net current liabilities
 Unplanned sales of non-current assets
(d) ISA 700 The auditor’s report on financial statements indicates the basic
elements that will ordinarily be included in the audit report.

List the basic elements of an auditor’s report and explain why each element is
included in the report.
Basic elements include:

Basic elements include:

 Title of ‘independent auditor’. To identify this as an audit report and
distinguish it from other reports on financial statements that might be
issued by others, directors, etc.
 Addressee. To identify the person(s) who may use or rely on the report.
 Opinion: the auditor’s opinion on the financial statements as at relevant
financial date and notes to the financial statements
 Basis for Opinion: stating audit conducted in accordance with International
standards on Auditing (ISAs). Stating independence of auditor and stating
the auditor’s view that that the audit evidence obtained is sufficient and
appropriate to provide a basis for our opinion.
 Key Audit Matters: outlining the matters that, in the professional
judgement of the auditors, were of most significance in the audit.
 Responsibilities of those charged with governance. Responsibilities of
entity’s management..
 Responsibilities of the auditors for the auditors of the financial statements
 Date of the report. To inform the reader that the auditor has considered
effects of transactions that the auditor became aware of on the financial
statements up to that date.
 Location of auditor’s office. This is normally the city where the auditor
responsible for the audit is located so he/she can be contacted, if
necessary.
 Auditor’s signature. This is normally the signature of the audit firm as the
firm assumes responsibility for the audit, not the individual engagement
partner.
EastVale Co

Fire at warehouse

(i) Audit procedures

 Discuss the matter with the directors checking whether the company has
sufficient inventory to continue trading in the short term
 Enquire that the directors are satisfied that the company can continue to trade
in the longer term. Ask the directors to sign an additional letter of
representation to this effect
 Obtain a schedule showing the inventory destroyed and if possible check this
is reasonable given past production records and inventory valuations
 Enquire that the insurers have been informed. Review correspondence from
the insurers confirming the amount of the insurance claim
 Consider whether or not EastVale can continue as a going concern, given the
loss of inventory and potential damage to the company’s reputation if
customer orders cannot be fulfilled

(ii) Amendment to financial statements

 Enquire whether the directors have considered whether the event needs
disclosure in the financial statements
 Disclosure is unlikely given that the inventory was not in existence at the year-
end and on the assumption that insurance is adequate to cover the loss
 Amendment is not required as the fire did not affect any company property
and the inventory would not have been in existence at the year-end (inventory
turnover being very high)

(iii) Modification of audit report

 Consider modifying the audit report with an emphasis of matter paragraph to

draw attention to the disclosure of the note on the fire in the financial
statements
 If the going concern status of EastVale is in doubt, then consider modifying
the audit report with an emphasis of matter paragraph to this effect
 If disclosure made by the directors is considered to be inadequate, then
modify the audit report with a qualified opinion

Batch of cheese
(i) Audit procedures

 Discuss the matter with the directors, determining specifically whether there
was any fault in the production process
 Obtain a copy of the damages claim and again discuss with the directors the
effect on EastVale and the possibility of success of the claim
 Obtain independent legal advice on the claim from EastVale’s lawyers.
Attempt to determine the extent of damages that may have to be paid
 Review any press reports about the contaminated cheese. Consider the
impact on the reputation of EastVale and whether the company can continue
as a going concern
 Discuss the going concern issue with the directors. Obtain an additional letter
of representation on the directors’ opinion of the going concern status of
EastVale

(ii) Amendment to financial statements

 The event should be disclosed in the financial statements in accordance with

IAS 37 Provisions, contingent assets and contingent liabilities as it may have
a significant impact on EastVale
 Over two-thirds of EastVale’s customers have either stopped purchasing
products from the company or are considering taking this action
 No adjustment is required for the event itself as it was not a condition at the
balance sheet date. However, the event may become adjusting if company’s
reputation has been damaged and the amount of the legal claim is significant
 In this situation the directors may decide that EastVale is no longer a going
concern so the financial statements may have to be re-drafted on a break-up
basis (the break-up basis is used where the directors have no realistic
alternative but to liquidate the company)

(iii) Modification of audit report

Modification of the audit report depends on the director’s actions above.

 If the financial statements are prepared on a break-up basis and the auditor
agrees with that assessment, then a modified report can be issued with an
emphasis of matter paragraph drawing attention to the accounting basis used
 If the going concern status of EastVale is in doubt, then consider modifying
the audit report with an emphasis of matter paragraph to this effect, drawing
attention to disclosure made by the directors
 If EastVale is not a going concern and the financial statements have been
prepared using this assumption, qualify the audit report with an adverse
opinion stating that the company is not a going concern
Auditing Postulates

1. Financial statements and financial data are verifiable.

 If this is not true, it is essentially impossible to carry out an audit, as an audit is

generally understood to involve the verification of reported facts.

2. There is no necessary conflict of interest between the auditors and the

management of the enterprise under audit.

 Either management or auditors would have to be assumed to be hostile to the

owners of the enterprise, with the other carrying out their duties to the owners
faithfully. Both management and auditors should be working for the owners.
 For there to be a conflict of interest, auditors would have to have an interest in the
outcome of the audit or in the performance of the enterprise and could therefore
no longer be assumed to be objective in their approach to the audit.
 Management would have no reason to co-operate with the audit, except for any
obligations specifically imposed by law.

3. The financial statements and other information submitted for verification are free
from collusive and other unusual irregularities.

 Auditors would not be able to rely on internal controls to prevent fraud and
irregularities which may lead to misstatements.
 Auditors would be unable to rely on independent evidence in assessing the
truthfulness of employees’ statements or of the documents produced. If the
possibility of collusive misstatements is admitted, every person in every
organization, including external organizations is assumed to have been suborned
by those who are attempting to misrepresent the company’s financial
performance or position or the nature of income or expenditure. It is therefore
never possible to obtain evidence that is known to be independent or accurate.

4. The existence of a satisfactory system of internal control eliminates the

probability of irregularities.

 Systems audit would become pointless – internal controls would mean nothing.
 Substantive testing would have to be so comprehensive that the costs of the audit
would outweigh the benefits for most large companies.
5. Consistent application of generally accepted accounting principles results in a fair
presentation of financial position and the results of operations.

 With no agreed standard for acceptable accounting policies, auditors would have
no basis for challenging doubtful policies, except for pure logic, which
shareholders and directors could not be guaranteed to understand.
 If the national standard setter could not produce a set of accounting standards
which results in a true and fair view, it is unlikely that anyone could. Therefore
there would probably be no such thing as a true and fair view of a company’s
financial activities and position. Therefore auditors could never report on the truth
and fairness of a company’s accounts, which would destroy the whole point of
doing an audit.

6. In the absence of clear evidence to the contrary, what has held true in the past
for the enterprise under examination will hold true in the future.

 Valuations of all non-monetary assets become meaningless if there is no

guarantee that any of them will remain useful or that the economic environment
will remain constant enough to allow them to be realized.
 The application of the going concern basis could never be appropriate because
the company would have to be assumed to be starting from scratch each year.
 The income statement would be meaningless as a tool for investment analysis.
 No reliance could be placed on the auditor’s experience of management controls
or management integrity.

7. When examining financial data for the purpose of expressing an independent

opinion thereon, the auditors act exclusively in the capacity of auditor.

 The auditors could not be relied on to examine the evidence most relevant to the
audit, because the needs of the auditors acting in some other capacity may be
given a higher priority.
 The auditors would lose their independence if they acted in any other capacity
(e.g. shareholder, management consultant or investment adviser).

8. The professional status of the independent auditors imposes commensurate

professional obligations.

 If auditors are not held responsible for their actions, there is no point in employing
them.
 There would be no point in auditors considering how best to do their work. They
would not have to do any work at all, let alone having to do it well. They would
have only powers, no responsibilities. This would mean that the question of how
to do an audit would become irrelevant to the only group in society who are in a
position to change how an audit is done.
Audit Development

a)
 An independent examination of, and expression of opinion on, the financial
statements of an enterprise by an appointed auditor in pursuance of that
appointment and in compliance with any relevant statutory obligation

b)
 Financial Statements audit
 Regulatory or compliance audits
 Management & operational audits
 Social audits

c)
 Right of access at all times to the company’s books accounts and vouchers
 The right to such info & explanations as they deem necessary to enable them to
form an opinion
 The right to receive notice and attend general meetings of the company and
receive all communications relating to such meetings
 The right to be heard at GM’s on business that concerns him as auditor
 The right to receive a copy of any written resolution proposed
 The right to require a meeting to lay the accounts and reports before the
company

d)
Students can discuss any two suitable cases e.g.
 London and General Bank (1895)
 Kingston Cotton Mill (1896)
 Candler v Crane, Christmas and Co. (1951)
 Caparo Industries v Dickman (1990)
 ADT v BDO (1995)
Typhoon

Compose a letter for Miss Forsate setting out:

(a) The criteria that you as external auditor would use to assess whether or not to
rely on work completed by the internal audit section

 Governed by professional auditing standard ISA 610

 External Audit carry out preliminary assessment of Internal Audit at planning
stage to determine if it is possible for them to rely on Internal Audit’s work
against four criteria:

 Organisational status: the specific status of internal auditing in the entity and
the effect this has on its ability to be objective
 Scope of function: the nature and extent of internal auditing assignments
performed
 Technical competence: whether internal auditing is performed by persons
having adequate technical training and proficiency as internal auditors
 Due professional care: whether internal auditing is properly planned,
supervised, reviewed and documented

(b) Whether or not you would use internal audit work to reduce the audit work
completed

 Responsibility for external audit opinion remains with external audit

 This responsibility cannot be reduced in anyway based on work completed by
internal audit
 Whether or not internal audit work is considered as evidenced will depend on
the outcome of the assessment of the internal audit section

(c) The respective responsibilities of management, internal auditors and external

auditors with regard to the computer breakdown

Management
 Primary responsibility for establishing and maintaining proper system of
internal control
 This would include developing, operating and maintaining IT systems
 It is therefore management’s responsibility to ensure that appropriate
corrective action is taken in respect of the computer breakdown
 Management would also be responsible for reporting any consequent material
loss in the financial statements

Internal auditors
 Primary function to assist management in reviewing system of internal control
 Review reasons for failure and whether or not management’s recovery
procedures were adequate
 Recommend improvements in system to prevent recurrence/mitigate any loss

External auditors
 Primary function to express opinion on truth and fairness of financial
statements
 Assess risk of breakdown causing material error or omission in accounts
 Review appropriateness of management disclosure in respect of any
consequential loss
 NOT external auditor’s responsibility to ensure system will not break down
again but will factor into extent to which you rely on it e.g. if no action taken
by management
Audit Independence

(a) Explain what is meant by the phrase “audit independence.”

Auditor is free from influences which may impair willingness to report objectively,
especially free from the influence of the company’s management.

(b) Explain the meaning of the following threats to external audit objectivity and
independence, describing, for each threat, at least two situations in which the
threat can arise:

i. The self-interest threat

Auditor’s own economic well-being may be adversely affected by giving an objective

opinion on the accounts:
 Shareholdings in client
 Fear of losing consultancy work
 Fear of not being reappointed as auditor

ii. The self-review threat

Auditor is checking own work:

 Acts as accountant for same company
 Has advised on accounting systems
 Has been auditor for several years and cannot now comment on errors not
detected in previous years’ accounts

iii. The familiarity threat

Auditor accepts facts presented rather than probing more deeply:

 After long relationship with audit client leads to accepting clients word at
face value
 Lack of rotation of audit team members

(c) For one of the threats identified in part (b) identify actions that the auditor can
take to limit the potential for the threat to arise.

Appropriate discussion as to how one of the threats in (b) can be minimised